1. Profile photo of anonymous says

    Sir, pls. correct me:

    Kd is the return required by the investors, which is different from cost to the company because of the existence of tax- (1-t).

    Ke though is the same as the cost of the company as there is no tax relief for equity.

    Am I right?

    • Profile photo of John Moffat says

      True – Kd is the return to investors which is pre-tax. The cost to the company is Kd(1-T) if it is irredeemable debt. However if (as is more likely in the exam) it is redeemable debt then it does not equal Kd(1-T) – we need to calculate the IRR of the after-tax flows (whereas Kd is the IRR of the pre-tax flows).

      • Profile photo of jay_azizi says

        Hi John,

        I am a little confused. You have mentioned that if debt is REDEEMABLE than it does NOT equal KDx(1-T). if that is the case than why in example 8 part 2 (redeemable debt) you have considered the coupon rate of 4.2 pa. That is $6 less 30%. If we were to follow your advise than the rate considered p.a should be 6% on nominal i.e. $6 because the example 8 states it is a redeemable debt.

        Appreciate your clarification.

      • Profile photo of John Moffat says

        The coupon rate gives the actual $ interest paid. This is allowable for tax and so the net payment is indeed $6 x 70% = $4.20.

        This is not the cost of debt. The cost of debt is part 2 is 10% whereas in part 1 (without tax) the return to investors is 11.86%

        The cost of debt does not equal the return to investors x 70%.

        As I explain in the lecture, it is because although the interest is tax allowable, the repayment is not tax allowable.

  2. Profile photo of anonymous says

    Hi Sir

    Example 7 part a, the cost of debt (kd) is 8.89%. After calculating you said that if the same was to be issued in stock market, the investors would desire the same return, otherwise why would they invest.
    I didn’t understand this.
    Also why is Kd calculated? the cost of debt is already known i.e, 8%. So when Kd is calculated, there will be 2 cost of debt percentages i.e, 8% and 8.89% . What is it’s difference?

    • Profile photo of John Moffat says

      8% is not the cost of debt. It is the coupon rate (the interest on nominal). Maybe when the debt was originally issued, 8% was an attractive rate. However, if investors were to buy the debt now on the stock exchange they would get a return of 8.89%. So if new debt were to be issued only offering 8% nobody would buy it – the company will have to offer 8.89% for it to be attractive.

      You may find the free F9 lectures on the cost of capital to be helpful.

  3. avatar says

    Very nice lectures, but i have a question plz help me to explain
    eg 7 & 8 in chapter 7. which one has higher cost btw for Irredeemable debt and redeemable debt? and you guest discount rate in example 8 based on what criteria ?. Your result is far than 6%

    • Profile photo of John Moffat says

      I am not sure what you mean by the first part of your question – they are two separate examples and in example 7 the cost of debt is 6.22% whereas in the second example it is 10%.
      The fact that one is irredeemable and the other redeemable just means that we do the arithmetic differently – it is not the reason that one has a higher cost that the other. Either of the two could have been higher.

      In example 8, we need to calculate the internal rate of return and the approach is exactly the same as when you calculated IRR for projects in Paper F9 – we make two guesses and then approximate between them to find where the NPV is zero. I guessed at 5% and 10% for part (a), but I could have made any two guesses.
      For part (b) I guessed at 10% (simply because 10% is in the middle of the tables). If the answer had not come so close to zero then I would have made a second guess and approximated in the same way as I did for part (a).

      There is no reason that the answer should be close to 6% which is the coupon rate. What we are trying to calculate in part (a) is the return that investors are currently getting if they buy the existing debt on the stock exchange. Since they are currently getting 11.86%, then there is no way that they would lend more money to the company unless they were offered 11.86% (but it would actually cost the company less because they get tax relief on the interest, which is why workings (b) are necessary).

  4. avatar says

    how does you got -0.77 i didn’t understand .from 1-5 year present value was 15.92 and at 5 year was 68.31 so what did you do to get -0.77.
    other thing is suppose answer is no close to zero but still negative so should we have to guess other percentage less then 10%

    • Profile photo of John Moffat says

      -0.77 is the net present value of the flows: 15.92 + 68.31 – 85 = -0.77

      We are calculating the Internal Rate of Return of the flows in exactly the same was as we do for projects (and as you did for F9) by making two guesses and then approximating between them (as we did in part (a) of this question).

      For part (b) I was ‘lucky’ because the NPV was virtually zero at 10% and so I did not need a second guess. If it was not so close to zero then I would have had to make a second guess and approximate in the same sort of way as for part (a).

  5. avatar says

    Dear lecturer,

    Thank you for your lesson.

    I have a question, too. Why the pricing in example 7 & 8 quoted in ex int (excluding interest?)

    And I can’t remember the difference in various debts. I remember there was a exam question about vanila bond. Can you give me a more detailed information about different type of debts?

    Thank you very much.

    • Profile photo of John Moffat says

      @annalla, Debt is always quoted ex int in the exam, unless you are told otherwise. Here the questions actually say that they are ex int (i.e. that interest has just been paid).

      Vanilla debt is debt with no unusual features (so not convertible, no warrants attached, no premium on redemption – just interest each year and then repayment at par.)

Leave a Reply